Lender of last resort
Tuesday, March 18, 2008 | Helmut Is this Spam?The history of Manias, Panics and Crashes shows that the presence of a lender of last resort has significantly lessened the impact of a crash that inevitably follows a mania that ends in a panic.
The game is like musical chairs – the mania is the dance, the panic sets in when the music stops and there are not enough chairs to sit on.
In the days before "enlightenment", crashes resulted in recessions and even "great" depressions. But now we have a lender of last resort, the Federal Reserve. It supplies the missing chairs so nobody has to panic.
Let's have a look at this in layman's terms. How many chairs are missing? Has the Fed got enough to supply them?
Chairs go missing because too many people transfer wealth to themselves based on "paper profits". Sooner or later, someone wants to cash in those paper profits and discovers that they are not "real profits".
That's when the rot sets in and the Fed steps in.
Let's assume the smart people have transferred 10% of the paper profits to themselves as real profits. What do you think? Is this percentage too high or too low?
According to http://www.fdic.gov/bank/statistical/stats/2007sep/industry.html, the banking system had $12.7 trillion in assets in September 2007, of which 10.45% was equity.
Is it reasonable to assume that those "assets" are paper assets, not real assets? And if so, is it reasonable to assume that the real assets are at least 10% less? In this case, all the banks between them have wiped out their equity.
Some, like Bear Sterns, wiped out more than their fair share. Some, like J P Morgan, are able to take advantage of the situation. A reminder of Black Thursday in 1929, when "Richard Whitney went from post to post on the floor of the exchange, placing bids for stocks in behalf of a syndicate headed by J. P. Morgan and Company" (Manias, Panics and Crashes p. 149).
Hypothetically, the depositors in the banking system could create a run and want to see their money. So? The lender of last resort would show it to them! Now what. Two possibilities – (i) you will leave it where it is; or (ii) you will take it back.
It's the second scenario that scares the Federal Reserve. If you take it back, you may not reinvest in US dollars but in Euros, C$, AU$, even Yen.
As a consequence, the US$ would collapse. Not a bad thing for the US, because in this case trillions in debt are being repaid at a few cents in the dollar; and US goods are going as cheap as third-world products, keeping everyone fully employed.
The only other consequence is that US living standards will become third-world standards too because the US dollar won't buy what is needed for a better standard.
Of course, as speculators, we don't care. To a speculator, every scenario presents an opportunity for profit.
